Monthly Archives: April 2016

I’m not sure exactly why I’m on a foreign markets/economies kick, but I think I’m pretty close to the end of it.

India and me

I’ve been fascinated/horrified by India economically for over twenty years. On the one hand, the country has lots of potential, based on a huge internal market and a large, well-educated workforce. On the other, economic success for India continues to rely on how favorable the monsoon season is. The country’s leaders are clearly aware of, and dismayed by, the fact that nations they may regard at any given time as peers soon leave India behind in the dust. But not that much has changed over the time I’ve been observing.

“Make in India’

“Make in India” is the marketing slogan the Narendra Modi administration has chosen to promote foreign direct investment, a time-honored tool for simulating economic progress through technology transfer. Think: Japan, Korea, Thailand, Malaysia, China… The road map is clear. The only question is whether a country has the political will to make the journey.

rules for success

I thought I’d try to list in this post, loosely in order of importance, what’s needed to attract foreign firms to create a business in a developing country. They are:

–a large pool of trained, or trainable, workers

–roads and ports, to get output from the manufacturing site to market

–sources of electric power, clean water and telecommunications

–a stable legal system, so the rules of the game are clear at the outset and the goalposts don’t get moved after a firm has committed capital

–protection for intellectual property. A generation ago, multinationals dealt with this crucial issue by sending to the Third World only the tools to make machines that were already obsolete in the First. By and large, that’s no longer a viable option. Because in today’s world technology transfer means not only how to organize and run a business but also current trade secrets, protection of intellectual property is more crucial than ever.

–it’s always nice to have a large internal market, so that the success of a factory doesn’t depend solely on export orders

–it’s also nice to have an eco-system of available suppliers and support industries grouped nearby.

How does India stack up?

It has a large internal market and a big pool of potentially available workers.

…

The physical infrastructure has never been great, in my experience …and India has never seemed to me to have effectively in made infrastructure development a high government priority.

India has always struck me as distinctly unwelcoming to newcomers, and to foreign enterprises in particular.

Mr. Modi says he wants to change that. Whether he will be able to is another question. So, too, is whether he really means what he says.

Contrary to market expectations, the Bank of Japan, that country’s equivalent of the US Federal Reserve, declined today to add to its already super-extraordinarily loose monetary policy.

Reaction in financial markets was in its own way extraordinary. The yen rose by 3% against the dollar and Japanese stocks fell by three percent. Not only that but ripples from the Tokyo decline have spread outward to Europe, and to the US in futures trading.

I can understand domestic Japanese distress.

Conventional economic theory says that if a country weakens its currency, lowers interest rates and ups government spending, all three forms of stimulus will act together to rev up consumer and corporate spending and thereby increase GDP. Upward wage pressure will ultimately emerge, however. This will create inflation, causing the economy in the end to settle back to its old, slower rate of real economic expansion. But the nominal figures will be higher because of the now-higher inflation rate.

Abenomics has done all the stimulus stuff, adding to already huge government debt and substantially reducing the purchasing power of ordinary citizens in the process. But there’s no sign of the economic growth or of the inflation (which Japan would love to swap for the deflation now plaguing it) that theory promises. Worse than that, the recent upward movement in the yen, helped along by today’s surge, has undone about a third of the currency weakening the government engineered a few years ago.

There are lots of possible reasons why Abenomics has not worked–aging population; resistance to immigration; entrenched, incompetent corporate managements; two political parties (one = pro-farming, the other = pro-North Korea, pro-pachinko, anti-nuclear weapons) with little relevance for modern Japanese life.

None of this is new. After all, Japan is more than halfway through its third decade of deflationary economic stagnation.

But why the flow-through to other markets?

Maybe this is just day traders’ reflexes and the weakness outside Japan will begin to dissipate once trading in New York begins. On the other hand, the EU has more than a passing resemblance to Japan. It’s just not quite as old. Maybe that’s what the world is starting to be worried about.

The original “Lucky Country” was Argentina. As I googled the term before writing this post, however, I found no trace of a link between the name and the South American agricultural giant.

Still, I began my international investing career in the mid-1980s with an Australian portfolio. In that Cro-Magnon time the Argentina/Australia comparison was common.

The idea for both nations was that they were endowed with abundant natural resources, but that this was a curse, not a blessing. That good luck spawned its opposite–excessive reliance on food/mineral production, insularity, dysfunctional government and resultant economic misery. In contrast, resource-poor places like Japan or Korea were blossoming as economic powerhouses.

the Dutch/Detroit disease

I stuck in the Detroit part. For me the Michigan analogy is much more current and powerful.

The Dutch “disease” was the discovery of gigantic offshore oil deposits. They required a lot of labor to develop–mostly strong backs and a willingness to spend long periods of time on floating oil development platforms.

The jobs required a lot of people, however, and paid maybe 3x normal wages. Combine that with a small national population and the result was soaring wages and, therefore, a mass migration of non-oil industries to other countries. When oil prices peaked in December 1980 and began a swoon that would reduce them by about 3/4, the oil business collapsed. Government finances fell apart and unemployment skyrocketed as laid-off oil workers couldn’t find new domestic jobs.

The “disease,” then, is small area and reliance on a single industry.

Detroit is the American equivalent, with automobiles instead of oil. The domestic auto industry grew fat and lazy in the 1970s-80s behind protective barriers erected against imports. It paid high wages that drove most other businesses out of the area. Heavy reliance on the “Big Three” car makers, corrupt government and the arrival of foreign auto manufacturers in lower-cost areas in the US eventually combined to drive the city into bankruptcy.

the Middle East

Economically, the typical oil producing country is Detroit in the desert.

Two twists on the all-eggs-in-one-basket theme:

— very young populations, meaning an imminent threat of significant youth unemployment; and

–a reluctance to allow women into the workforce.

Both probably turn them into Detroit on steroids.

I have no idea how this all works out. Dubai, which has no oil, is looking a lot smarter than it did six or seven years ago. The recent Saudi announcements of a radical restructuring of its economy are just the curtain being raised on what may be a lengthy, twisty-plot drama, I think.

Over the past few days, as a new, younger generation prepares to take over leadership of Saudi Arabia, the kingdom has been announcing plans to overhaul the structure of its radically oil-dependent economy.

The most concrete of these is a proposed IPO for the Saudi national oil company, Aramco (the Arabian American Oil Company before it was nationalized in the 1970s). The idea would be to sell roughly a 5% interest in Aramco to the investing public, with a dual listing in Saudi Arabia and somewhere else. The leading “somewhere else” contender is the US.

It’s not clear yet exactly what the future shareholders would have an ownership interest in. Aramco contains all sorts of oil-related operations, from exploration and production to refining to petrochemical production. The Saudis intend to restructure Aramco into a holding company with subsidiaries–structured presumably by type of business–before offering equity. To me, it sounds as if the offering will be of stock in a subsidiary, not the holding company.

Why?

money

The obvious answer is that the kingdom wants to raise money to fund its budget deficit. It figures the proposed IPO will raise $100 billion – $150 billion, a figure that already has investment bankers around the world salivating. This, by the way, implies a total value for Aramco of $2 trillion – $3 trillion.

deeper motivation

But there’s almost invariably a deeper motivation when a country takes action like this. It wants to focus and streamline operations of the to-be-IPOed company, either because current service is terrible and/or to generate more funds from operations to fill government coffers. The IPO offers potential wealth and prestige to the management of the government-owned company if they run it well. That substitutes for pre-IPO motivation, which may simply be to do the least work possible, and make the fewest waves, without getting fired.

better than they look

In my experience, such IPOs, however dreary the prospectus may sound, often do quite well for at least the first couple of years. Two reasons:

–their scope for change becomes much wider when public scrutiny protects the manager from interference by politically-connected sluggards who like the status quo, and

–managers tend to, in a sense, stop working once they find out an IPO is in the offing. Why make improvements today that will only make post-IPO earnings comparisons harder? Better to save them for the time when the stock is publicly traded and holders of stock, stock options and management incentive plans will cash in on them.

in sum

The IPO itself is evidence that the Saudis are serious about a reorientation of their economic priorities. Human nature argues that 2016 will be like wading through molasses for Aramco but that it will break very quickly from the gate after the IPO.

The recent Labor Department determination that all financial advisors making recommendations for individuals’ retirement savings must act as fiduciaries is reviving interest in the topic of mutual fund/ETF fees and expenses.

Being a fiduciary means that the advisor has to place the client’s interest ahead of his own. It isn’t permissible, for example, for a fiduciary to recommend an investment that is likely to return 5% per year, for selling which he gets a large commission, over a virtually identical one that will return 8%, but which pays a small commission. For a non-fiduciary, which is what brokers/financial planners are when dealing with non-retirement assets, pushing the low return/high commission alternative is still ok legally.

Personally, I don’t like it that the fiduciary standard doesn’t apply to non-retirement investments. I also don’t understand why individual investors don’t appear to be worked up about this. I do understand why the big banks are opposed to fiduciariness, since applying the fiduciary standard to all advice to individuals strikes at the heart of the profits of the traditional “full service” brokerage industry.

12b-1 fees

The 12b-1 part refers to the section of the Investment Company Act of 1940 that governs how an open end mutual fund is allowed to pay for fund distribution and servicing. It covers things like advertising, sending materials to prospective shareholders or having a call center to answer questions about the fund.

The general idea is that a fund benefits from retaining existing shareholders and adding new ones, so it’s a legitimate use of shareholder money to promote both objectives.

But the most common use of funds under the 12b-1 rule–and the least well understood, in my view–is periodic payments to financial advisors by a fund while clients continue to hold shares. In the industry, these payments are called “trailing commissions,” or “trailers.”

The SEC doesn’t limit the amount of this fee, although FINRA (the Financial Industry Regulatory Authority, the investment industry trade group) rules set an effective cap of 1.0% of fund assets yearly. My sense is that the most common fee percentage for an equity fund is 0.25% – 0.50%. The best hard data I can find come from the ICI (Investment Company Institute, a mutual fund trade group), and are from 2003. At that time, aggregate 12b-1 fees amounted to just under half the total administrative expenses, at 0.43% of assets annually. The rest were old-fashioned (more clearly understood by customers) sales charges.

why is 12b-1 a current issue?

Historically, disclosure of these fees has been exactly crystal clear. Try finding information about them on the ICI website, if you don’t believe me. In fact, I can’t recall having met anyone not involved in selling mutual funds who was aware these fees exist.

So, does a broker/financial planner who advises a client on retirement investments in mutual funds have to make sure the customer understands that 12b-1 fees are being subtracted from NAV on a regular basis? Once he gets that, does the customer put two and two together and realize he’s subject to these fees on non-retirement investments, too–and has been from day one?

How does he react?

The difficulty I’ve experienced in gathering factual data for this post tells me that fund companies think the reaction will be strongly negative.

MSFT reported earnings for its fiscal third (=March) quarter after the close yesterday.

My takeaways:

–the company had a good quarter for its future-oriented cloud and mobility businesses during a period where the legacy PC business was unusually weak. In the latter arena, MSFT did substantially better than the market.

–the strength of the dollar continues to be a drag

–income tax. Geographically, the US has been stronger than expected, emerging markets weaker. One result of this development is that MSFT has adjusted its estimate for the corporate tax rate for the full year from 19% to 21%. The full revision for the first nine months was made in the 3Q income statement, boosting the March quarter tax rate to 24% (this is normal accounting procedure). That clipped $.04 from what eps would otherwise have been.

–company guidance for upcoming quarters is being revised down somewhat, in a justifiably cautious way. The dollar is one issue. But the bigger headache seems to me to be weakness in Latin America, the Middle East and Africa, where lots of transactional (as opposed to long-term contract) business takes place and where tax rates are lower.

–today’s selloff appears overdone to me. That’s partly the way markets move nowadays, reacting violently to headline news. It’s also partly because MSFT had been up by 35% over the past year in a market that has been basically flat over the same time span.

–I’m not tempted to transact. I see no reason to sell the shares I own. If anything, I’d be a buyer below $50. But I see no reason to rush.

Representatives from a large group of national oil companies, both Opec and non-Opec, met in Doha last weekend, ostensibly to see if they could mutually agree not to raise their oil production from current levels.

From a practical economic view, the conclave made little sense. Because all the countries involved are strapped for cash, they’re already producing flat out. The only exception is Iran, which declined to participate. It is ramping up its output for the first time in a long while now that sanctions are being lifted, and has no intention of stopping.

It was clear from the outset that the best outcome would be an agreement where the parties said they wouldn’t do what they couldn’t do anyway. So Doha was all about optics, about satisfying internal political demands that the local oil ministries were leaving no stone unturned. Weird, maybe, but understandable if you’re an oil functionary who wants to keep his job.

Nevertheless, there was an immediate spike down in the oil price when failure to reach agreement was announced. To my mind this was more traders playing games in the market than an expression of dismay.

More interestingly:

–crude oil prices are higher today than they were before Doha, and

–Brent crude, a proxy for non-US demand for oil (because it can be used in older refineries), is beginning to establish its traditional premium over West Texas Intermediate.

my thoughts

We passed the seasonal low point for oil demand in mid-February and are entering the strongest seasonal period now. So it makes some sense that the price should be strengthening.

The Brent premium suggests US drivers aren’t the only ones consuming more oil products. The lower price may also be stimulating usage in the rest of the OECD, where petroleum taxes are much higher.

The (crazy) period of securities trading where low oil was thought to be a harbinger of recession appears to be behind us.

My guess is that traders will continue to search for a price ceiling, which I think is around $50 a barrel.

I wonder if the major non-government owned oil companies have been holding back production on the idea that prices are too low, thereby, consciously or not, aiding the recovery process. This wouldn’t be much different from how these firms acted during the period of oil price controls in the US in the 1970s -1980s.